Liquidating a corporation: how to structure a plan of liquidation to avoid unanticipated tax liabilities.

• Author: Caraway, Karla J.

Before the Tax Reform Act of 1986 (TRA) was enacted, a corporation generally did not recognize any gain or loss on the distribution of property in liquidation, or from corporate asset sales conducted pursuant to a plan of liquidation. (1) Corporate assets sales are now fully taxable, and distributions in liquidation are treated as a deemed sale of property between the corporation and its shareholders for fair market value (FMV) on the date of distribution. (2) This deemed sale can present valuation problems if not an arm's-length transaction. This article will discuss the issues connected with the liquidation of a corporation--valuation of assets, limitations on losses for certain liquidating distributions and other problem areas--and offer planning opportunities and techniques to minimize the overall tax consequences of a liquidation.

Distribution of Assets

Sec. 336(a) provides, in general, that a liquidating corporation will recognize gain or loss on the distribution of its property in a complete liquidation as if the property were sold to its shareholders at FMV. If, however, any of the assets are subject to a liability, or if the shareholder assumes a liability, FMV cannot be less than the liability. (3) This corporate "exit tax" will reduce the amount of assets available to distribute to the shareolders. See Example 1 on page 149.

While there is no limitation on the recognition of gain from a liquidating distribution, statutory anti-abuse provisions may restrict the recognition of losses. (These loss limitations will be discussed in detail later in the article.)

The distribution of assets in liquidation of the corporation will be treated as full payment in exchange for the shareholder's stock. The amount of gain or loss recognized by the shareholder will be the difference between the FMW (net of liabilities) of the assets received and the shareholder's basis in his canceled stock. (4)

Example 2: A, the sole shareolder of ABC Corporation in Example 1, has a tax basis in his stock of $750,000. A receives a liquidating distribution of $814,900 and recognizes a gain of $64,900 ($814,900 -- $750,000).

The gain or loss recognized by the shareholder is generally capital in nature. However, there are exceptions to this general rule (which will be discussed later).

Concerns of the

Liquidating Corporation

* Valuation of assets

In theory, the tax consequences of a liquidation should be the same whether the corporation sells assets to a third party and then distributes the proceeds to its shareholders or simply distributes all assets in liquidation. However, the deemed sale created by a distribution may produce valuation problem not present in an actual sale to a third-party purchaser. Because the burden of proof of valuation is on the taxpayer, the corporation should retain a qualified appraiser to defend the value assigned to the assets.

Obtaining an appropriate value for individual assets is not the only concern for the liquidating corporation. Since a liquidating distribution is a deemed sale of all corporate property, the IRS may seek to value the company as a going concern, if a shareholder continues the business as a sole proprietorship, prietorship, with a resultin valuation in excess of the aggregate vlaue of the company's identifiable assets. In this regard, it is necessary to consider the applicability of Sec. 1060. If Sec. 1060 applies to the deemed sale, it is possible that an allocation to goodwill or going concern value would be required, increasing the corporate and shareholder tax burden.

* Rules and applicability of Sec. 1060

Under pre-TRA law, there existed a competing interest between buyers and sellers in the allocation of purchase price in asset purchases. Sellers generally benefited from a larger allocation to capital assets, including goodwill or going concern value, because of preferential capital gains taxation. Buyers generally benefited from a larger allocation to depreciable tangible assets or amortizable intangible assets, with goodwill or going concern allocations avoided to the extent possible. This adverse interest between the buyer and seller gave the allocation of a fixed purchase price to individual assets a measure of credibility. When the TRA eliminated preferential capital gains taxation, selles could be expected to be indifferent to how a lump-sum sales price was allocated, since this allocation generally no longer had an effect on their tax liability. As a result, Congress was concerned about potential abuses in purchase price allocations, with particular emphasis on the assignment of value to goodwill or going concern value. Its response was to enact Sec. 1060, which mandates the use of the "residual method" of valuation to asset acquisitions. (5)

Sec. 1060 applies to any "applicable asset acquisition," which is defined as any direct or indirect transfer of assets that constitute a trade or business in the hands of either the seller or the purchaser, and with respect to which the transferee's basis is determined solely by reference to the consideration paid for the assets. (6) The regulations issued under Sec. 1060 define a group of assets to constitute a trade or business if -- the use of the assets would constitute an active trade or business for purposes of Sec. 355; or -- the character of the assets is such that goodwill or going concern value could attach to those assets. (7)

Sec. 1060(a) provides that a lump-sum purchase price will be allocated among specific assets using the residual method approach prescribed in Sec. 338(b)(5). Under the Sec. 338 temporary regulations, the residual method allocates the purchase price to identifiable tangible and intangible assets, up to their FMV, with any remainder allocated to...